INTERNATIONAL CERTIFICATE

IN CORPORATE FINANCE®

TEXTBOOK
***********************************************

 Chapter 2 – Earnings

© Copyright 2015 FIRST FINANCE INSTITUTE– All rights reserved 1

 Chapter 2

Earnings

Following our analysis of company cash flows, it is time to consider the issue of how a
company creates wealth.

© Copyright 2015 FIRST FINANCE INSTITUTE– All rights reserved 2

SECTION 1: ADDITIONS TO WEALTH AND DEDUCTIONS FROM WEALTH

What would your spontaneous answer be to the following questions?

 Does purchasing an apartment make you richer or poorer?
 Would your answer change if you were to buy the apartment on credit?

There can be no doubt as to the correct answer. Provided that you pay the market price
for the apartment, your wealth is not affected whether or not you buy it on credit.

When you buy an apartment, you become neither richer nor poorer, but your cash
decreases. Arranging a loan makes you no richer or poorer than you were before (you
owe the money), but your cash has increased.

Raising debt is tantamount to increasing your financial resources and commitments

at the same time. As a result, it has no impact on your net worth. Buying an
apartment for cash results in a change in your assets (reduction in cash, increase in
real estate assets) without any change in net worth.

Spending money does not necessarily make you poorer. Likewise,

receiving money does not necessarily make you richer.

The job of listing all the items that positively or negatively affect a company’s wealth
is performed by the income statement1, which shows all the additions to wealth
(revenues) and all the deductions from wealth (charges or expenses or costs).
The fundamental aim of all businesses is to increase wealth. Additions to wealth
cannot be achieved without some deductions from wealth. In sum, earnings represent
the difference between additions to and deductions from wealth.

Revenues Gross additions to wealth

– Costs – gross deductions from wealth
= Earnings = net additions to wealth (deductions from)

Earnings represent the difference between revenues and costs, leading to

a change in net worth during a given period. Earnings are positive when
wealth is created and negative when wealth is destroyed.

Since the rationale behind the income statement is not the same as for a cash flow

1 Also called a Profit and Loss statement or P&L account.

© Copyright 2015 FIRST FINANCE INSTITUTE– All rights reserved 3

statement, some cash flows do not appear on the income statement (those that
neither generate nor destroy wealth). Likewise, some revenues and costs are not
shown on the cash flow statement (because they have no impact on the company’s
cash position).

1. EARNINGS AND THE OPERATING CYCLE

The operating cycle forms the basis of the company’s wealth. It consists of both:
 additions to wealth (products and services sold, i.e. products and services
whose worth is recognized in the market); and
 deductions from wealth (consumption of raw materials or goods for resale, use
of labor, use of external services such as transportation, taxes and other
duties).

The very essence of a business is to increase wealth by means of its operating cycle.

Additions to wealth Operating revenues

Deductions from wealth – Cash operating costs
Earnings before interest, taxes,
= depreciation and
amortization (EBITDA)

It may be described as gross insofar as it covers just the operating cycle and is
calculated before non-cash expenses such as depreciation and amortization, and
before interest and taxes.

2. EARNINGS AND THE INVESTING CYCLE

a) Principles

Investing activities do not appear directly on the income statement. In a wealth-

oriented approach, an investment represents a use of funds that retains some value.

To invest is to forgo liquid funds: an asset is purchased but no wealth is

destroyed. As a result, investments never appear directly on the income
statement.

That said, the value of investments may change during a financial year:
 it may decrease if they suffer wear and tear or become obsolete;
 it may increase if the market value of certain assets rises.

© Copyright 2015 FIRST FINANCE INSTITUTE– All rights reserved 4

Even so, by virtue of the principle of prudence, increases in value are recorded only if
realized through the disposal of the asset.

b) Accounting for a decrease in the value of fixed assets

The decrease in value of a fixed asset due to its use by the company is accounted for
by means of depreciation and amortization.2

Impairment losses or write-downs on fixed assets recognize the loss in value

of an asset not related to its day-to-day use, i.e. the unforeseen diminution in the
value of:
 an intangible asset (goodwill, patents, etc.);
 a tangible asset (property, plant and equipment);
 an investment in a subsidiary.

Depreciation and amortization on fixed assets are so-called “non-cash”

costs insofar as they merely reflect arbitrary accounting assessments of the
loss in value.

As we shall see, there are other types of non-cash costs, such as impairment losses on fixed
assets, write-downs on current assets (which are included in operating costs) and
provisions.

3. THE DISTINCTION BETWEEN OPERATING COSTS AND FIXED

ASSETS

Whatever is consumed as part of the operating cycle to create something new belongs
to the operating cycle. Without wishing to philosophize, we note that the act of
creation always entails some form of destruction.

Whatever is used without being destroyed directly, thus retaining its value, belongs to
the investment cycle. This represents an immutable asset or, in accounting terms, a
fixed asset (a “non-current asset” in IFRS terminology).

4. THE COMPANY’S OPERATING PROFIT

From EBITDA, which is linked to the operating cycle, we deduct non-cash costs,
which comprise depreciation and amortization and impairment losses or write-downs
on fixed assets.

2 Amortization is sometimes used instead of depreciation, particularly in the context of intangible assets.

© Copyright 2015 FIRST FINANCE INSTITUTE– All rights reserved 5

This gives us operating income or operating profit or EBIT (Earnings Before Interest
and Taxes), which reflects the increase in wealth generated by the company’s
industrial and commercial activities.

Operating profit or EBIT represents the earnings generated by

investment and operating cycles for a given period.

The term “operating” contrasts with the term “financial”, reflecting the distinction
between the real world and the realms of finance. Indeed, operating income is the
product of the company’s industrial and commercial activities before its financing
operations are taken into account. Operating profit or EBIT may also be called
operating income, trading profit or operating result.

5. EARNINGS AND THE FINANCING CYCLE

a) Debt capital

Repayments of borrowings do not constitute costs but, as their name suggests, merely
repayments.

Just as common sense tells us that securing a loan does not increase wealth, neither
does repaying a borrowing represent a cost.

The income statement shows only costs related to borrowings. It never

shows the repayments of borrowings, which are deducted from the debt
recorded on the balance sheet.

We should note that the interest payments made on borrowings lead to a decrease in
the wealth of the company and thus represent an expense for the company. As a
result, they are shown on the income statement.

The difference between financial income and financial expense is called net
financial expense/ (income).

The difference between operating profit and net financial expense is called profit
before tax and non-recurring items.3

b) Shareholders’ equity

From a cash flow standpoint, shareholders’ equity is formed through issuance of

3 Or non-recurrent items.

© Copyright 2015 FIRST FINANCE INSTITUTE– All rights reserved 6

shares minus outflows in the form of dividends or share buy-backs. These cash
inflows give rise to ownership rights over the company. The income statement
measures the creation of wealth by the company; it therefore naturally ends with the
net earnings (also called net profit). Whether the net earnings are paid in dividends
or not is a simple choice of cash position made by the shareholder.

6. RECURRENT AND NON-RECURRENT ITEMS: EXTRAORDINARY

AND EXCEPTIONAL ITEMS, DISCONTINUED OPERATIONS

We have now considered all the operations of a business that may be allocated to the
operating, investing and financing cycles of a company. That said, it is not hard to
imagine the difficulties involved in classifying the financial consequences of certain
extraordinary events, such as losses incurred as a result of earthquakes, other
natural disasters or the expropriation of assets by a government.

They are not expected to occur frequently or regularly and are beyond the control of a
company’s management – hence, the idea of creating a separate catch-all category for
precisely such extraordinary items.

By definition, it is easier to analyze and forecast profit before tax and non-recurrent
items than net income or net profit, which is calculated after the impact of non-
recurrent items and tax.

SECTION 2: DIFFERENT INCOME STATEMENT FORMATS

Two main formats of income statement are frequently used, which differ in the way
they present revenues and expenses related to the operating and investment cycles.
They may be presented either:
 by function,4 i.e. according to the way revenues and costs are used in the
operating and investing cycle. This shows the cost of goods sold, selling and
marketing costs, research and development costs and general and
administrative costs; or
 by nature,5 i.e. by type of expenditure or revenue which shows the change in
inventories of finished goods and in work in progress (closing minus opening
inventory), purchases of and changes in inventories (closing minus opening
inventory) of goods for resale and raw materials, other external costs,
personnel expenses, taxes and other duties, depreciation and amortization.

4 Also called by-destination income statement.

5 Also called by-category income statement.

© Copyright 2015 FIRST FINANCE INSTITUTE– All rights reserved 7

Thankfully, operating profit works out to be the same, irrespective of the
format used!

The two different income statement formats can be summarized by the following diagram:

The by-nature presentation predominates to a great extent in Italy, Spain and Belgium.
In the US, the by-function presentation is used almost to the exclusion of any other
form6

Whereas in the past France, Germany, Switzerland and the UK tended to use
systematically the by-nature or by-function format, the current situation is less clear-

6 The US airline companies are an exception as most of them use the by-nature income statement.

© Copyright 2015 FIRST FINANCE INSTITUTE– All rights reserved 8

cut. Moreover, a new presentation is making some headway; it is mainly a by-
function format but depreciation and amortization is not included in the cost of goods
sold, in selling and marketing costs, or research and development costs, but is
isolated on a separate line.

1. THE BY-FUNCTION INCOME STATEMENT FORMAT

This presentation is based on a management accounting approach, in which costs are

allocated to the main corporate functions:

Function Corresponding cost

Production Cost of sales
Commercial Selling and marketing costs
Research and development Research and development costs
Administration General and administrative costs

As a result, personnel expense is allocated to each of these four categories (or three
where selling, general and administrative costs are pooled into a single category)
depending on whether an individual employee works in production, sales, research or
administration. Likewise, depreciation expense for a tangible fixed asset is allocated
to production if it relates to production machinery, to selling and marketing costs if it
concerns a car used by the sales team, to research and development costs if it relates
to laboratory equipment, or to general and administrative costs in the case of the
accounting department’s computers, for example.

The underlying principle is very simple indeed. This format clearly shows that
operating profit is the difference between sales and the cost of sales irrespective of
their nature (i.e. production, sales, research and development, administration).

On the other hand, it does not differentiate between the operating and investment
processes since depreciation and amortization is not shown directly on the income
statement (it is split up between the four main corporate functions), obliging analysts
to track down the information in the cash flow statement or in the notes to the
accounts.

2. THE BY-NATURE INCOME STATEMENT FORMAT

The by-nature format is simple to apply, even for small companies, because no
allocation of expenses is required. It offers a more detailed breakdown of costs.

Naturally, as in the previous approach, operating profit is still the difference between
© Copyright 2015 FIRST FINANCE INSTITUTE– All rights reserved 9
sales and the cost of sales.

In this format, costs are recognized as they are incurred rather than when the
corresponding items are used. Showing on the income statement all purchases made
and all invoices sent to customers during the same period would not be comparing like
with like.

A business may transfer to the inventory some of the purchases made during a given
year because the staple has not been transformed. The transfer of these purchases to
the inventory does not destroy any wealth. Instead, it represents the formation of an
asset, albeit probably a temporary one, but one that has real value at a given point in
time. Secondly, some of the end products produced by the company may not be sold
during the year and yet the corresponding costs appear on the income statement.

To compare like with like, it is necessary to:

 eliminate changes in inventories of raw materials and goods for resale from
purchases to get raw materials and goods for resale used rather than simply
purchased;
 add changes in the inventory of finished products and work in progress back to
sales. As a result, the income statement shows production rather than just
sales.

The by-nature format shows the amount spent on production for the period and not
the total expenses under the accruals convention. It has the logical disadvantage that
it seems to imply that changes in inventory are revenue or an expense in their own
right, which they are not. They are only an adjustment to purchases to obtain relevant
costs.

© Copyright 2015 FIRST FINANCE INSTITUTE– All rights reserved 10